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Activity-based costing (ABC) 

What is it?

Practice

CIMA Official Terminology describes activity-based costing as an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects. The latter use cost drivers to attach activity costs to outputs.

ABC was first defined in the late 1980s by Kaplan and Bruns. It can be considered as the modern alternative to absorption costing, allowing managers to better understand product and customer net profitability. This provides the business with better information to make value-based and therefore more effective decisions.

ABC focuses attention on cost drivers, the activities that cause costs to increase. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received. In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products.

The activity-based costing process:
Activit-based costing process

 

What benefits does ABC provide?

Activity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them. ABC enables effective challenge of operating costs to find better ways of allocating and eliminating overheads. It also enables improved product and customer profitability analysis. It supports performance management techniques such as continuous improvement and scorecards.

Questions to consider when implementing ABC

  • Do we fully understand the resource implications of implementing, running and managing ABC?
  • Do we have the resources to implement ABC?
  • Will the costs outweigh the benefits?
  • Can we easily identify all of our activities and costs?
  • Do we have sufficient stakeholder buy-in? What will it take to achieve this?
  • Will the additional information ABC provides result in action that will increase overall profitability?
Actions to take / Dos Actions to Avoid / Don'ts
  • Get buy-in from the rest of the business. ABC provides business managers, as well as the finance function, with the information needed to make value-based decisions
  • Use ABC for pricing and product prioritisation decisions
  • ABC should be implemented by management accountants as they are best placed to manage the process and to ensure benefits realisation
  • Do not get caught up in too much attention to detail and control. It can obscure the bigger picture or make the firm lose sight of strategic objectives in a quest for small savings
  • It is important not to fall into the trap of thinking ABC costs are relevant for all decisions. Not all costs will disappear if a product is discontinued, an example being building occupancy costs

 

 

In practice:
Activity-based Costing

 
 

How Xu Ji achieved standardisation in working practices and processes
(CIMA case study, 2011)

The Chinese electricity company Xu Ji used ABC to capture direct costs and variable overheads, which were lacking in the state-owned enterprise’s (SOE) traditional costing systems. The ABC experience has successfully induced standardisation in their working practices and processes. Standardisation was not a common notion in Chinese culture or in place in many Chinese companies. ABC also acts as a catalyst to Xu Ji’s IT developments – first accounting and office computerisation, then ERP implementation.

Prior to the ABC introduction in 2001, Xu Ji operated a traditional Chinese state-enterprise accounting system. A large amount of manual bookkeeping work was involved. Accounting was driven predominantly by external financial reporting purposes, and inaccuracy of product costs became inevitable. At this time, Xu Ji underwent a series of flotations following China’s introduction of free market competition.

The inaccuracy of the traditional costing information seriously impeded Xu Ji’s ability to compete on pricing. The two main tasks for the ABC system were to: trace direct labour costs directly to product and client contracts; and allocate manufacturing overheads on the basis of up-to-date direct labour hours to contracts.

Lessons learned

The common ‘top-down’ management style and organisational culture among SOEs worked well when instigating innovative ideas and inducing corporate-wide learning. Top management’s commitment to trying out new management ideas and investing in new technology has been the unique feature.

 

 

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‘Over the past 15 years, ABC has enabled managers to see that not all revenue is good and not all customers are profitable customers.’
Kaplan and Anderson.

Time-driven activity-based costing. HBR, November 2004